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The management of accounting numbers – case study evidence

from the ‘crash’ of an airline

Ann Jorissen (University of Antwerp)

David Otley (Lancaster University Management School)

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Abstract

Earnings management has usually been analysed by large­scale empirical research.

However, the generality gained from such an approach is at the cost of understanding the

rich and complex nature of earnings management in real organizations. Responding to a

plea in the literature that most studies on earnings management did not take an

integrated perspective and generally failed to distinguish appropriately between what is

endogeneous and exogeneous, we adopt a case study approach based on internal

company data to gain more insight into the managerial incentives which drive the

decision to engage in earnings management and the underlying processes which are

triggered by this decisions. Through such a qualitative analysis we are able to uncover

facts which contradict previous findings.

Using a multi­theory perspective we observe that the direction of the causation assumed

in the agency framework is often reversed and that managerial incentives to engage in

earnings management are influenced by the strategic choice of the top management team

and the contents of the non­negotiable contracts of the firm. The case findings provide

insights into a number of additional variables, uncovered by prior empirical studies,

which enlarge the discretion of the CEO to engage in earnings management.

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Introduction

In the autumn of 2001 two major European airlines, the Swiss airline Swissair and the

Belgian flag carrier Sabena, ceased to exist. These corporate collapses, especially that of

Swissair (part of SAirgroup), came as a surprise to many people. A report undertaken at the

request of the administrator of the SAirgroup was finalized in January 2003 1 and the

accompanying press release stated:

“The unconsolidated and consolidated financial statements for 1999 and, to a much greater

degree, for 2000, did not fairly present the economic and financial situation of the

SAirgroup”.

The group had thus succeeded in presenting information about its financial position and

performance which was substantially different from the true underlying economic performance.

Unfaithful representation of economic performance through accounting numbers (Lee, 2006) or

earnings management, is not a new phenomenon and it has been researched for many years.

However, due to several scandals at the start of the 21sth century (e.g. Enron, Worldcom,

Parmalat, Ahold) research in the broad domain of earnings management has intensified. The

majority of studies adopt the definition of Healy and Wahlen (1999) that “earnings management

occurs when managers use judgment in financial reporting and in structuring transactions to alter

financial reports to either mislead some stakeholders about the underlying economic performance

of the company, or to influence contractual outcomes that depend on reported accounting

numbers (Healy and Whalen, 1999)”

1 (‘The Investigation Report’ ‘Ernst & Young Bericht in Sachen Swissair’)

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These studies try to understand why managers manipulate earnings, how they do so and what the

influences and consequences of this behaviour are (Mc Nichols, 2000), although they follow

different theoretical paradigms.

First, there is a capital market stream, mostly grounded in the agency theory (Jensen and

Meckling, 1976; Fama and Jensen, 1983) which focuses primarily on the incentives embedded in

the external and internal contracts governing the firm. (e.g. Barth, Elliot & Finn, 1995; De

Angelo, De Angelo and Skinner, 1996; Hunt, Moyer and Shevling, 1995; Degeorge, Patel and

Zeckhauser, 1999; DeFond and Jiambalvo, 1994; Sweeney, 1994; Key, 1997; Han and Wang,

1998; Healy, 1985; Holthausen, Larcker and Sloan, 1995; Bartov, 2001). This stream of research

also tries to identify those situations which lead to inefficient contracting whereby the discretion

provided to managers enables them to increase their wealth by altering the accounting numbers

(e.g. Hope, 2003; Leuz, Nanda and Wysocki, 2003; Donelly and Lynch, 2002; Ball, Kothari and

Robin, 2000). Second, research on earnings management within the critical perspectives

literature concentrates mainly on the contextual variables which facilitate or incite management to

manipulate accounting numbers (e.g. Brillof, 2001, Revsine, 2002, O’Conell, 2004; Benston and

Hartgraves, 2002; Lee, 2006; Williams, 2004). The results of this stream of research emphasize

the importance of improved regulatory enforcement to the provision of better quality financial

information to stakeholders. Third, the governance literature attempts to provide insight into the

role of governance quality and board monitoring in restraining earnings management (e.g. Boyd,

1994; Beasly, 1996; Peasnell, Pope and Young, 2001).

Despite these numereous studies, Fields, Lys and Vincent (2001) argue that only modest progress

has been made because there have been few attempts to take an integrated perspective and also

because accounting research generally failed to distinguish appropriately between what is

endogeneous and exogeneous. Dechow and Skinner (2000) state that the lesson from accounting

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research is that measures of earnings management devised by academic researchers have not been

very powerful in identifying the practice. Dechow and Skinner (2000) argue therefore that a more

fruitful way to identify firms whose managers practice earnings management is to focus on

managerial incentives. With this paper, we want to respond to these pleas. By adopting a case

study approach based on internal company data and by taking an integrated perspective, we

attempt to shed light on the distinction between which variables are exogeneous and which have

an endogeneous character in relation to earnings management. Next we try to gain additional

insights on the managerial incentives which stimulate the decision to engage in earnings

management through a multi­theory lens on the case data. Further we try to uncover mechanisms

facilitating earnings management, in addition to those revealed by agency research.

Most studies of earnings management (especially in the capital market and governance

literatures) adopt a quantitative approach using large scale public archival data bases. A small

minority of articles adopt a different methodology. For example, Nelson (2002, 2003) and

Graham (2005) used survey research in order to detect the drivers of earnings management and

the methods employed to manage accounting numbers. A number of studies in the critical

perspectives literature (Benston and Hartgraves, 2002; Lev, 2002; Arnold and de Lange, 2004;

Baker and Hayes, 2004 ) and Lys and Vincent (1995) and de Jong, De Jong, Mertens and

Roosenboom (2007) situated in the capital market based stream, used a case study approach.

However all these case studies are based on publicly available financial data.We opted for a case

study based on internal company data as it provides for a richer exploration of the

interrelationships among the variables which stimulate or influence earnings management and the

processes which are triggered by the decision to engage in earnings management. Through such a

qualitative analysis we are able to uncover facts which contradict previous research findings.

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This paper distinguishes itself from other studies by the character of the research methodology

(case study) applied in combination with the data employed (internal company data). It also uses

a multi­theory approach which explicitly considers the central role of top management in the

decision to engage in earnings management.

The agency studies implicitly assume that managers make decisions on a rational, economic self­

interested basis and that they all react in an identical way to incentives, opportunities and

constraints embedded in the contracts governing the firm. However, the management literature,

grounded in Cyert and March’s ‘behavioural theory of the firm‘ (1963), indicates that managers

are often faced with bounded rationality and that they must act in a social context of multiple and

conflicting goals. Based on Cyert and March’s concept of bounded rationality, Hambrick and

Mason (1984) elaborated upper­echelons theory which suggests that an organization becomes a

reflection of its top executives and that the characteristics and functioning of the top management

team have a great influence on organizational outcomes. These complimentary perspectives from

management theories provide a richer theoretical context for a study on the incentives and

methods of earnings management.

The paper is structured as follows. In the next part, the variables which will guide our

framework of analysis will be derived from the literature. In the third part, the research

method and the case company will be outlined. In the fourth part, the case data which relate

to the longitudinal analysis of the strategic choice and the earnings management methods

employed will be presented and discussed. In the final part of the paper we develop the

insights derived from the multi­theory approach on the process of earnings management.

The analysis of the case data reveals that the direction of causation assumed by earnings

management studies framed in agency theory is often reversed. When accounting choices are

determined endogeneously with the strategic choices of top management, a reverse causation for

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those contracts of the firm which top management is able to renegotiate is observed. The non­

negotiable contracts of the firm in combination with the strategic choice of top management

shape the adopted reporting strategy. Further the case results indicate that mainstream

empirical research has not uncovered all the variables embedded in the organization and its

environment which create discretion and opportunities for earnings management. On addition to

the variables already revealed by agency research namely: company characteristics and

institutional variables, we observe the need for the CEO to create the necessary internal discretion

by altering a number of internal organizational and management variables such as: the

composition of the dominant coalition in the firm, the organizational structure, the investment

characteristics and the management control systems of the company.

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2. Literature review

This review of the literature will outline the content and limits of prior research and point to gaps

in the existing literature that our study will address. Second , a framework for analysis will be

developed which will guide the choice of events to analyse in the case study.

2.1. Overview of the accounting literature

As mentioned in the introduction we define earnings management using the widely adopted

definition of Healy and Wahlen (1999). If we analyze this definition of earnings management

and relate it to the extant literature, we make two major observations. First, the definition of

earnings management encompasses the management of balance sheet numbers as well as the

management of earnings numbers. The majority of studies in the literature however constrain

earnings management exclusively to the management of the earnings numbers. Only a few studies

examine the management of balance sheet numbers (Shevling, 1987; Ely, 1995; Bauman, 2003)

despite their importance, for example, in connection with covenants and credit ratings.

Second we notice that the definition of Healy and Wahlen allows two possible methods for

influencing accounting numbers. We distinguish accounting earnings management (or accruals

management i.e. manipulations by reference to selective interpretation of accounting regulations)

from real earnings management (i.e. management operating decisions made to achieve desired

accounting numbers). Most studies to date have analyzed earnings management by studying only

accruals management (Dechow, Sloan and Sweeney, 1995; Beneish, 1997; Mc Nichols, 2000).

Only a limited number of studies have studied the practice of real earnings management (see

Roychowdury 2006, Wayne, Hermann and Inoue, 2004). In addition, a few studies analyze

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earnings management by capturing the overall impact of both methods on the earnings figure of a

company by using “distributional” studies, which test whether the distribution of earnings around

benchmarks differs in some predicted way from what would be expected in the absence of

earnings management (Burghstahler and Dichev, 1997; Degeorge, Patel and Zeckhauser 1999;

Beatty and Petroni, 2002).

This observation implies that only research on earnings management through accruals is well

developed. However analytical studies (Ewart and Wagenhofer, 2005) and recent survey research

(Nichols, Elliot and Tarpley. 2002, 2003; Graham, 2005) provide evidence that corporate

management uses both methods to influence the accounting reports. Nichols et al. (2002)

suggests that detailed guidance in accounting standards reduces earnings management achieved

through management judgments (=accounting earnings management or accruals management)

and increases earnings management achieved through transaction structuring (= real earnings

management). In this study we will consider both accounting and real earnings management as

methods employed by corporate managers to influence earnings as well as balance sheet

numbers.

We now consider the research stream which tries to uncover the drivers of earnings management.

Evidence is available that listed firms have an incentive to show a recurrent and increasing stream

of earnings (Barth, Elliot and Finn, 1995; De Angelo, De Angelo and Skinner, 1996) together

with low earnings volatility (Hand 1989; Bartov 1993; Hunt, Moyer and Shevlin, 1995); to avoid

small losses (Burghstahler and Dichev, 1997) and to meet benchmarks or targets (Degeorge, Patel

and Zeckhauser, 1999; Kasznik, 1999). Contracts with debtholders also provide all firms with

stimuli to engage in earnings management in order to avoid violation of debt covenants and in

order to obtain a favourable credit rating (De Fond and Jiambalvo, 1994; Sweeney, 1994;

Dechow, Sloan and Sweeney; 1996). Further research indicates that contracts with regulatory

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authorities provide an incentive to earnings management to avoid regulatory intervention (Key,

1997; Han and Wang, 1998) or to minimize taxation (Beatty, Chamberlain and Magliolo, 1995;

Guenther, Maydew and Nutter, 1997) .

Earnings management is also stimulated by the implicit and explicit internal contracts of the firm.

The threat of a performance­related CEO turnover creates incentives to match industry

performance (De Fond and Park, 1997; Fudenberg and Tirole, 1995). The incentive to perform

stimulates new CEOs to engage in big bath accounting in their first year of office (Pourciau,

1993; Murphy and Zimmerman, 1993; Godrey, Mather and Ramsay, 2003). Further, ample

evidence is available that reward and bonus plans, which represent the explicit internal contracts

of the firm, drive earnings management (Healy, 1985; Gaver, Gaver and Austin, 1995;

Holthausen, Larcker and Sloan, 1995; Guidry, Leone and Rock, 1999; Bartov, 2001).

A feature of all these studies in this stream of research is that they assume that the incentives for

earnings management are embedded in the contracts governing the firm and that these are

independent variables, which are exogeneous in relation to earnings management.

Prior literature (both capital market based literature focusing on inefficient contracting and the

critical literature) has uncovered opportunities for top management to engage in the management

of accounting numbers. This research indicates that the degree of ownership concentration affects

the nature of contracting and that accounting informativeness declines as ownership concentration

increases (Dempsey, Hunter & Schroeder, 1993; Warfield, Wild & Wild, 1995; Donelly &

Lynch, 2002; Fan & Wong, 2002). Further evidence shows that institutional characteristics such

as the quality of accounting standards (Pope & Walker, 1999; Ball, Kothari & Robin; 2000; Ali &

Hwang, 2000), the degree of investor protection (LaPorta, Lopez­de­Silanes, Shleifer & Vishny,

1997; LaPorta, Lopez­de­Silanes & Shleifer, 1998), the risk of litigation (Ball, Kothari and

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Robin, 2000; Leuz & Verrechia, 2000) and the degree of enforcement (Hope, 2003) all create

opportunities for earnings management. Research which focuses on board characteristics and its

relation to earnings management, provides evidence that when the quality of board monitoring is

impaired by the presence of CEO­duality, interlocking CEOs and internal or grey directors further

opportunities for earnings management arise.

The findings of the accounting literature on earnings management are summarized in Figure 1

below. The relationships presented here will also guide our analysis of the case data in part four

of the paper.

[ insert figure 1 here ]

2.2 The management literature: insights from the upper­echelons theory and strategic choice

theory

The extant accounting literature has not taken into account heterogeneity among the

characteristics of top managers and its possible impact on earnings management. We will

combine insights from the “upper­echelons” tradition in the organization studies literature with

the findings from the accounting literature in order to take a multi­paradigm perspective on why

and how managers manipulate earnings. Upper echelons theory suggests that executives will

make decisions that are consistent with their cognitive base (including values, cognitive models

and personality factors, Hambrick and Mason, 1984) and executive orientation (Finkelstein and

Hambrick, 1996). A fundamental principle of upper echelons theory is that observable

experiences (i.e. demographic measures like tenure, age, functional and educational background)

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are systematically related to the underlying cognitive orientations and knowledge base. In these

theoretical frameworks, the organization becomes a reflection of its top executives, whereby the

CEO functions as the central strategic decision­maker who is able to control the composition of

the organization’s top strategy making group (Zahra and Pearce, 1989). A large number of

studies, triggered by Hambrick and Mason’s (1984) paper provide evidence that

differences in CEO characteristics and top­management­team (TMT) composition (with

respect to dimensions such as tenure, gender, functional and ethnic background, and age)

have an impact on a range of organizational outcomes such as turnover, innovation,

diversification, and organizational performance (Hambrick and Fukutomi, 1991; Jensen

and Zajac, 2004). This implies that a deeper knowledge of the managerial characteristics of the

CEO and of the factors that determine the distribution of power among corporate managers is

required to advance the knowledge on the presence of earnings management and how it is

achieved. As a result we will consider the following insights from power circulation theory and

strategic choice theory, when we analyse the earnings management process. According to power

circulation theory (Ocasio, 1994; Ocasio, 1999) an inside succession following a CEO’ dismissal

reflects a successful internal power contest against the CEO, and the successor is a contending

executive who has won the support and approval of the board of directors. Because power

contestation and CEO dismissal often occur in periods of poor firm performance (Ocasio, 1994;

Puffer and Weintrop, 1991) contender successors will often be charged with initiating strategic

change and improving firm performance. Insights from strategic choice theory reveal that CEOs

chose to initiate a strategic change which closely matches their prior pattern of strategic choice

and which is consistent with their previous background.

3. Research Method

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3.1 Framework of analysis

Figure 1 describes the framework used to study the earnings management process in the case

company. It reveals the contracts we need to consider and the variables which might represent

available discretion for corporate management to engage in earnings management. We will look

both for the management of balance sheet numbers and the management of earnings numbers. To

do this we will use the definition of accounting choices articulated by Fields, Lys and Vincent

(2001) and operationalized by Francis (2001). Fields, Lys and Vincent define accounting choices

as any decision whose primary purpose it is to influence (either in form or in substance) the

output of the accounting system in a particular way, including not only published financial

statements , but also tax returns and regulatory filings (Fields, Lys and Vincent, 2001). According

to Francis (2001) these accounting choices can be categorized into the following groups: choices

among equally acceptable rules; judgments and estimates required to implement generally

accepted accounting rules; disclosure decisions; timing decisions of when to adopt a required

accounting rule; choices about display; aggregation decisions; classification decisions; decisions

to structure transactions in certain ways to achieve a desired accounting outcome; real production

and investment decisions. We will adopt this classification to study the accounting choices

applied by the SAirgroup.

It is impossible to study all accounting choices made by the SAirgroup over 10 years. Since we

want to try to go beyond previous research results and challenge some prior hypotheses, we

have chosen a disaggregated approach in the study of accounting choices. According to Francis

(2001) the disaggregated approach features a focus on individual accounting items known to

require substantial managerial judgment and to have a significant impact on reported profitability.

This disaggregated approach has the potential advantage of yielding precise directional

predictions based on the researchers understanding and analysis of how decision makers trade off

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the incentives associated with the accounting object of the study (Francis, 2001). This implies that

we will combine multiple motives with multiple accounting choices in relation to an individual

accounting item with a substantial impact on the financial statements of the SAirgroup. The key

element in classifying a decision as an accounting choice is the managerial intent, especially with

real decisions; that is, whether the impetus behind the decision is to affect the output of the

accounting system or whether the impetus derives from other motives (Fields, Lys and Vincent,

2001). We will provide evidence of managerial intent using internal company documents.

3.2 The case company and the competitive environment

A case study allows to provide insights into management processes which are difficult to

produce with quantitative research (Gephart, 2004) and can suggest new explanations that

have not been previously considered. The focus on a single group of companies [the

SAirgroup (former Swissair Group)] makes it possible to incorporate the richness and

complexity of the context in a study of accounting choices. The companies involved in the

case are located in different jurisdictions that have different domestic accounting standards,

different levels of investor protection and different degrees of enforcement related to

compliance with accounting standards. This case therefore has the characteristics of a small

natural experiment which allows us to study the opportunities these context specific

influences offered. Further, within the SAirgroup itself, a quasi­experimental setting can be

distinguished since the passenger transport business segment was operating in a more

regulated environment then the other strategic business units of the SAirgroup (such as

catering, ground handling, cargo transport, and information systems).

The data used in this case study are primarily internal archival company data. Access was

gained to internal company documents dealing with strategic decisions, operating decisions,

top management bonus schemes and financial reporting. A list of internal documents used is

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provided in Appendix A. For triangulation purposes (Yin, 2003; Miles and Huberman,

1998) these archival internal company data are combined with the annual reports of the

SAirgroup, the prospectuses issued by the SAirgroup in the late nineties and publicly

available data from sources outside the group (see also Appendix A). A number of

interviews with members of the management team of the airlines were also held. Given the

judicial enquiries around the bankruptcies of both airlines caution must be exercised in the

interpretation of these interviews and the potential bias in national press reports requires to

be recognized.

From the internal documents we collected data on strategic choices, CEO characteristics,

accounting choices, multiple motives or incentives (i.e. external and internal contracts governing

the firm) and sources of discretion over a time span of 10 years (1991­2001). Until 1990 Swissair

(or Swiss Air Transport Company Ltd) only published individual accounts in compliance with

Swiss GAAP. From 1991 onwards the Swissair Group published consolidated accounts and

therefore this year is chosen for the start of the longitudinal analysis. Over the total time span of

the study the Swissair/SAirgroup was a listed company, quoted on the Zurich stock exchange,

with dispersed ownership. In order to finance its activities the Swissair/SAirgroup relied on share­

issues and issues of public debt as well as issues of private debt.

Within that time frame the competitive and regulatory environment of the airlines in Europe

changed substantially. Despite some deregulation in the US and the European Union, the airline

industry in the 1990s was still characterized by a high degree of regulation. In the EU (except for

the UK where the process began earlier) the first steps towards deregulation appeared at the end

of the 1980s about ten years later than in the US. From 1993 European skies became open for

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‘community carriers’ 2 . That is, EU airlines are free to operate across national boundaries within

the EU. Switzerland, situated in central Europe, is not a member of the European Union. In the

early nineties there was a possibility that Swissair would enjoy the same rights as EU community

carriers if the Swiss people voted in favor of joining the European Economic Area. Despite a very

active publicity campaign, partly financed by Swissair, in favour of a yes­vote the Swiss people

rejected (by a small majority) entry into the European Economic Area in late 1992. Swissair

management was very disappointed by this decision and faced major strategic choices about how

it was to develop its business from its position outside of the EU.

They communicated the consequences of the “no” vote in its subsequent annual reports:

“Switzerland remains aeropolitically isolated at the heart of the continent, and Swissair

and Crossair continue to suffer the disadvantages such isolation brings”.

(Message to the shareholders, Annual Report, 1995).

These national and EU decisions provided a very specific context within which a set of real and

accounting decisions were taken.

4. The analysis of the case data

Since we intend to apply a multi­theory analysis on the issue of earnings management, we will

present first the longitudinal analysis of the strategy of the Sairgroup together with the changing

CEO­characteristics viewed through the lens of the upper­echelons theory in combination with

the power circulation theory and strategic choice theory. Then we will analyse the accounting

choices made during a 10 year period along the framework of analysis presented in Figure 1.

4.1. The strategy of an airline: 1990 – 2001

2 An airline qualifies as a ‘community carrier’ under the EU regulation (EC ordinance 2407/92 of July 23, 1993) when the majority of the capital is in the hands (in a direct way or an indirect way) of persons or companies belonging to the European Union.

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Within this time frame, two CEO turnovers took place. We therefore distinguish three subperiods

within those 10 years.

4.1.1. The Swissair group or a group around the airline Swissair: 1990­ 1995

Until the start of the 1990s the profits of airlines were secure due to the high degree of

regulation and price agreements. Following deregulation in the early 1990s, the results of

Swissair came under pressure. The CEO in the early 1990s, Otto Loepfe, was a man with an

airline background who had to face the competition created by deregulation in Europe. In

response to these pressures Swissair first tried to form an alliance (under the name Alcazar)

with KLM, Austrian Airlines and SAS. This project was unsuccessful and negotiations were

terminated in November 1993. As a result, Swissair had to look for other means to face the

stronger competition caused by the deregulation in the EU and to circumvent their

“aeropolitical isolation”.

On May 4 th , 1995, Swissair acquired a large minority shareholding of 49.5% in the capital of

Sabena, the Belgian state­owned national flag carrier. The investment deal between Swissair

and Sabena was structured so that it formally complied with the EU regulation on passenger

air transport. Through the EU approval of this acquisition Sabena still qualified as a

‘community carrier’ yet it gave the Swiss airline group access to the EU air transport market.

In addition to the investment of 49.5% in the share capital of Sabena, a loan of 151 million

Swiss francs (CHF) was granted by Swissair to the Belgian government which held the

remaining 50.5% of the share capital. This loan entitled Swissair to raise its equity holding

in Sabena from 49.5% to 62.25% when the bilateral agreements between Switzerland and

the EU would change in the future. Then Sabena would no longer lose its ‘community

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carrier’ status by having a Swiss majority owner. At the time of the acquisition in mid­1995

the aim of the investment in Sabena was stated to be to develop a single airline group

concentrated around the two equal hubs of Zurich and Brussels. The airlines were considered

to be the core business of the Swissair group although other airline­related activities were

performed.

4.1.2 The transition of the Swissair group into the SAirgroup: 1996­2000

Due to the weak results of Swissair an unplanned performance­related CEO turnover took place

early 1996. Philippe Bruggisser was chosen as successor. In the early 1990s he had successfully

implemented a growth strategy in the legally independent division, Swissair Associated

Companies (SAC), of the Swissair Group which was active in the catering and the hotel business.

Although the succession was an intra­group succession, he was not an intra­airline industry

replacement. as he had a financial background. Before running the SAC, he had worked for a

Swiss bank in the 1980s. Research in the management literature suggests that people with a

financial background typically regard firms as a collection of assets that need not be associated

with a single line of business (Jensen and Zajac, 2004). Given the functional background of the

new CEO, and perhaps the fact that at the time of succession he had less airline expertise,

Philippe Bruggisser diversified the corporate strategy of the Swissairgroup by launching his

“dual” strategy. An event which can be interpreted as supporting a variant of the ability­matching

model which suggests that a CEO may attempt to increase his value to the firm by changing the

business mix of the firm to one for which his managerial skills are uniquely well suited (Shleifer

and Vishny, 1989).

The dual strategy formally separated the airline business (= passenger transport) from the

support activities surrounding it. The message to the shareholders in the Annual Report of

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1996 gave more details about the new company structure, the new company name and the

contents of the dual strategy:

“Swissair has moved from its traditional structure as an airline to become a corporate

group that conducts airline­related activities in addition to actual airline operations. The

new group structure, named the SAirgroup will underscore the diversity of the new

corporation. ….SAirgroup – more than just an airline. The group is divided into four

general areas of emphasis in spring 1996. The airline activities are bundled together in

the SAirlines division. Aircraft maintenance and handling, information technology and

real estate administration are all part of the SAirServices division. SAirLogistics is

responsible for the marketing, sale, handling and warehousing of cargo and offers our

customers global logistic solutions. SAirRelations focuses exclusively on gastronomy, the

hotel trade and the travel retail business.”

The launch of the dual strategy was accompanied by a drastic change in the organizational

design of the group. After the creation of the new holding structure and the organizational

re­design, the legal entity of the airline Swissair remained responsible only for passenger

transport and had to buy all related services from companies which now belonged to other

strategic business units (SBU) in the SAirgroup. Even ownership of the aircraft was

transferred to a new legal entity, Flightlease, which provided leasing services from 1998 on

to other airlines in which the SAirgroup had equity holdings and third party customers. The

legal entity Swissair representing passenger transport was only left with intangible (but

valuable) assets such as traffic rights, slots at airports and a dominant position at its hub

airport, Zurich.

The “dual strategy” (referred to the airline as the ‘first pillar’ and to the support services or

airline­related services as the ‘second pillar’) was launched by the new CEO as a growth

strategy to be pursued by acquisitions and organic growth in all four SBUs of the SAirgroup

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(SAirlines, SAirservices, SAirrelations and SAirlogistics). Graph 1 reflects the steep rise in

revenue of the SAirgroup following the new dual strategy.

[Insert graph 1 about here]

Acquisitions in the support service or airline­related business took place from 1996 and

continued during the following years. Most of the acquisitions were characterized by an

acquisition of a majority of the shares.

In the first pillar of the SAirgroup, i.e. passenger transport, growth through acquisitions

started in 1998, when SAir management started to implement the “Hunter Strategy,”which

was developed at the end of 1997 in cooperation with a well known worldwide consulting

company, and foresaw alliances with other European national airlines:

“The intended expansion of Swissair was focused on countries, airports and markets with

large growth potential (Belgium, Austria, Finland, Hungary, Portugal and Ireland), and

not on the mature markets as Germany, France and Italy. In addition, the Zurich airport

was to be used as a central hub and expanded. The hunter strategy was conceived as a

moderate investment strategy with clearly minority investments (10%­30%) and defined

capital requirements (CHF 300 million).” 3

The first acquisitions following adoption of this strategy took place in the fall of 1998 and

were followed by further acquisitions in 1999. However, the type of companies acquired and

the terms of acquisition did not match the originally conceived strategy (see citation above),

as shown in Table 1 .

Table 1: Overview of the investments made under the Hunter Strategy

Year Country Company % of shareholdings

1998 Germany LTU 49,90 % 1998 France Air Litoral 49,00 % 1998 Italy Air Europe 49,90 %

3 See press release accompanying the report ‘Results of the investigation regarding Swissair’.

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1998 Italy Volare 34,00 % 1999 France AOM 49,50 % 1999 Poland LOT 37,60 % 1999 South Africa SAA 20,00 % 2000 Italy Volare Group

out of Air Europe and Volare

49,79 %

Source; Annual Reports of the SAirgroup 1998­2000

It can be seen that most acquired airlines were in the more mature markets, and most stakes

exceeded the 30% threshold defined in the espoused strategy, although they were always less

than a formal majority holding.

The published net income up until 1999 ( as demonstrated in graph 2) communicated a successful

turnaround of the Swissair Group into the SAirgroup due to the strategic change initiated by the

new CEO.

[insert graph 2 about here]

If we analyze Bruggisser’s strategy of the early nineties in the catering business, which brought

him celebrity and the top position in the SAirgroup, we notice that it consisted of two items,

namely acquisitions of other catering companies (e.g. the catering division of British Airways)

and the restructuring of the catering activity of Swissair. From 1993 onwards Swissair had to buy

catering services from the SAC instead of providing them internally. The underlying business

model of the dual strategy launched in 1996 was a copy of his strategy of the early nineties. The

2 nd pillar SBUs of the SAirgroup grew through acquisitions and the delivery of services to the

airlines in which the SAirgroup had an equity stake. The dual strategy was a growth strategy

22

which required substantial financial resources and a record of financial success to support further

fund­raising.

4.1.3. The return to Swissair: 2001

Despite these promising accounting numbers in the years 1997, 1998 and 1999, financial

problems emerged openly for the first time in mid­ 2000. In January 2001 the CEO of the

SAirgroup, who had launched the dual strategy in 1996, was dismissed. The new

management team pinpointed the cause of the serious financial problems of the SAirgroup in

the first pillar of the SAirgroup, namely passenger transport, and more specifically in the

foreign airlines in which the SAirgroup had invested. The letter of the new Chairman

communicated this view in the following message in the 2000 Annual Report (page 4)

“In the annals of our company’s history the 2000 business year will be remembered as a

poor one. The SAirgroup did not meet the targets established for the airline sector. The

substantial losses stemming from our airline equity holdings were responsible for a very

inadequate result. The SAirLogistics, SAirServices and SAirRelations divisions, forming

the second pillar of our dual strategy, have either met or surpassed their performance

targets.”

The result of the SAirgroup had reached a dramatically low level in 2000, and the problems

intensified in 2001. In July 2001 the SAirgroup divested the two French airlines and in

August 2001 the relationship with Sabena was renegotiated. On October 2nd 2001,

following the events of 9/11, the SAirgroup holding company, SAirlines, the airline Swissair

and Flightlease all filed for bankruptcy. Consequelntly the SAirgroup did not fulfill

agreements it had concluded with Sabena on a capital injection meant to take place in

October 2001. Sabena was declared bankrupt on November 7, 2001. Thousands of

employees lost their jobs in Switzerland, Belgium and in other countries in which the two

airline groups were active.

23

4.2. A longitudinal analysis of accounting choices in the SAirgroup: 1991 – 2001

The accounting numbers presented in graph 1 (revenue) and 2 (net income) together with graph 3

below, indicate that the accounting numbers for the years 1997, 1998 and 1999 had characteristics

(increasing revenue and increasing earnings combined with low volatily of earnings) which are

appreciated by the capital market.

[Insert graph 3 about here]

The financial structure of the SAirgroup improved as well over that time period (1997­1999).

The increase in the equity/total debt ratio was needed in order to obtain a favorable credit rating

when public debt was issued in 1999 and early 2000.

Table 2: evolution of the equity/total debt ratio over 1996 – 2000

1996 1997 1998 1999 2000

Equity/total

debt

17,8 % 19,3% 20,3% 24,1% 5,7%

Source: Financial Statements of the SAirgroup 1996, 1997, 1998, 1999 and 2000

The huge loss of 2000, despite the still increasing revenue (see graph 1), and the bankruptcy in

the autumn of 2001, seem to be in total contradiction to the financial information published in

the years before. The report requested by the Administrator of the bankrupt airline revealed that:

24

“The unconsolidated and consolidated financial statements for 1999 and, to a much greater

degree, for 2000, did not fairly present the economic and financial situation of the

SAirgroup”.

Using a disaggregated approach we will chose an accounting item which has a major impact on

the financial statements in order to examine how this divergence between the underlying

economic performance and the published performance represented by the accounting numbers

arose. Because the new management team of 2001 blamed the foreign airlines in which the

SAirgroup invested for the financial problems of the SAirgroup (see citation in 4.1.3), we will

concentrate on the accounting choices made by SAirgroup in its consolidated accounts for the

investments it undertook in foreign airlines. Using the classification of Francis (2001) we will

discuss the choice among the accounting methods or rules, the judgments and real decisions in the

text. The other choices which relate to display, aggregation, classification and disclosure will be

presented in table format ( see section 5.1).

4.2 The accounting choices of the Swissair group: 1990­1995

Up until 1995 the consolidated accounts of the Swissair Group were prepared in accordance with

the 4th and 7 th EU Directives on company financial reporting and with the provisions of the Swiss

Law. (Note 1 of the Group Accounts of the Swissair Group, 1991 until 1995). In Switzerland

under Swiss GAAP, as in several other countries influenced by the conservative German view of

accounting, income smoothing is formally permitted by law and substantial hidden reserves can

be created. According to Dumontier & Raffournier (1998) most Swiss companies make

considerable use of hidden reserves by recognizing excessive depreciation of assets or creating

unjustified provisions. In the individual accounts published by Swissair in the 1980s we notice

that in all years except 1986, substantial amounts of supplementary depreciation had been

25

recorded and hidden reserves were created when the actual aircraft load factor was above the

break­even aircraft load factor. These “hidden reserves” were released in the opposite situation,

which occurred in the early nineties (1991­1994) 4 . So the flexibility of Swiss GAAP thus allowed

Swissair management in the 1980s and early 1990s to smooth income and to shift earnings into

the later years, providing the perception of smooth and continuing good performance (see graph

2).

In relation to its investment in Sabena mid­1995, the essence of the acquisition was to

foresee in the contracts a framework which made it possible to take control over Sabena,

without violation of the EU Regulation on passenger air transport. The consulting report

“Flair”, prepared by a well­known consulting firm at the request of Swissair in relation to

this acquisition, pointed to this critical element in making the acquisition successful.

Through the terms of the different agreements namely the Shareholders’ and Management

Agreement between Swissair and the Belgian State, dated 4 May 1995, on the one hand and

the Cooperation Agreement between Swissair and Sabena, dated 24 July 1995, on the other

hand Swissair would be able to obtain a substantial amount of management power and

effective control 5 and the documents were drafted to formally comply with the EU

regulation on transport.

4 When hidden reserves are released this has to be disclosed in the notes to the annual accounts according to article 663 par 8 of the Swiss Company Law 5 The SMA stipulated that the Board of Directors of Sabena consisted of 12 members from which at least 7 had to be EU­citizens. Six out of those 12 directors were chosen by the Belgian government, five were appointed by the Swissair/SAirgroup and one director namely the Chairman of the Board had to be chosen in consensus by the Belgian government and the Swissair/SAirgroup. If no consensus could be reached the Swiss shareholder could appoint a candidate (art. 7 of the SMA). For the removal of the directors a special majority was needed, this implied that a Belgian director representing the Belgian government could not be removed without the approval of the Swiss shareholder. The addendum of 12 June 1995 to the SMA stated further that the appointment of a CEO had to be approved by the majority of the members of the Board of directors. The CFO and the middle management of Sabena could be proposed by Swissair (addendum 7 to the SMA). Further according to the SMA the decision to hire and fire top managers in the Sabena Group was in the hands of the CEO of Sabena, who needed the approval of the Board to execute these decisions.

26

For the valuation of the investment in Sabena in the books of the Swissairgroup, the group also

needed to comply with the 7 th EU Directive, which contains standards for consolidated accounts.

If a standard is considered as a total body of principles and rules that apply to a given

accounting issue (Nelson, 2003), the standards which deal with the issue of control, embedded in

the 7 th Directive, have a strong rules­based character (see Appendix B). Rules­based standards

deal with specific settings and are defined in detail. As a result rules­based standards allow

creative managers to create innovative transactions (Kershaw, 2005) and provide an opportunity

for preparers to engineer their way around the intent of the standard. Whether or not a transaction

can be structured as such to evade the rules, depends on the precision of the accounting standard.

If this method of real earnings management is pursued, financial reporting that is not

representationally faithful to the underlying economic substance of transactions can follow. In

order to counter­balance the rules­based character of the 7 th EU Directive, the Directive contains

a true and fair override which allows companies and auditors not to follow a standard if its

application results in financial statements which do not present a true and fair view of the

company’s financial position, results and cash flow. In continental Europe the true and fair

override was seldom applied ( Benston, Bromwich and Wagenhofer, 2006).

So Swissair, based on the legal form of the Shareholders’ and Management Agreement chose to

account for Sabena using the equity method 6 . Full consolidation of Sabena in the books of

Swissair could have been interpreted by the EU as evidence that Swissair was controlling Sabena,

so it appears that the equity method was used to avoid such a risk. At this stage the choice of the

equity method instead of full consolidation did not create any difference with regard to the

published net result of the Swissair Group. Only the debt structure of the Swissair Group

6 the choice between the full consolidation and equity method can have a major effect on the group accounts of the investor. Under full consolidation the investor takes all assets and liabilities of the investee into its consolidated accounts. Under equity accounting the invester shows the investment in its consolidated accounts at the accounting value of that investment in the investee’s books.

27

benefited from this choice, since it enabled the Swissair Group to keep the liabilities of Sabena

off their own balance sheet.

In accordance with the application of the equity method 49.5% of the loss incurred by Sabena in

1995 influenced the profit and loss account of the Swissair Group in 1995 under the single line

item ‘share in the result of associated enterprises’, which is the prescribed classification practice

if one accounts for an investment under the equity method. Graph 3 and Graph 4 (Sabena group)

indicate that both groups realized an operating profit in 1995, whereas the net result was negative.

However, in both groups these losses were mainly the result of accrual decisions.

[Insert graph 4 about here]

“The extraordinary expenditure relates almost entirely to provisions made for planned

corporate restructuring activities”

(Annual Accounts Swissair Group 1995, page 10, Note 9).

In the annual accounts of Sabena an extra­ordinary depreciation item was recorded in order to

harmonize the fleet with the SAirgroup in the years to come:

“The group result for 1995 remained in the red to the tune of BEF 1,620 million. This includes

an exceptional provision of BEF 1,090 million for the renewal of the fleet”

(Annual Report Sabena Group, 1995, page 5).

4.2.2 The accounting choices of the SAirgroup 1996 ­ 2000

In 1996 the SAirgroup switched to the IAS standards promulgated by the IASC for the

preparation of its group accounts. These IAS standards are more principles­based. Further the

conceptual framework of the IASC, which defines the characteristics of accounting information

28

states explicitly that transactions should be accounted for in compliance with their economic

substance rather than with their legal form. Contrary to the 7 th Directive, the International

Accounting Standards define the principle of control in general and explain the idea further in

IAS 27 (see Appendix C). IAS 27 (par 4) defines the principle of control as: “the power to govern

the financial and operating policies of an entity so as to obtain benefits from its activities.”

4.2.2.1 Accounting choices in relation to the investment in Sabena

In 1996 the SAirgroup started to use the possibilities foreseen in the Shareholders’ and

Management Agreement as well as in the Cooperation Agreement for taking control over Sabena,

despite having only a minority stake. From early 1996 onwards the position of CEO and CFO of

Sabena were occupied by employees of the SAirgroup who had their incentive and reward

contracts tied to the results of the Swissair/Sabena Steering Committee, the committee where

strategic and operating decisions affecting both airlines were taken. Further early 1996 new

subcommittees were created to the Board of Directors of Sabena and SAir employees played an

important role in those. In the finance committee SAir employees held 50% of the votes and in

the remuneration committee SAir employees held the majority of the votes.

Although IAS 27 states explicitly that control can exist even when the parent owns less than one­

half of the voting power of an enterprise but when there is the power to govern the financial and

operating policies of the enterprise under statute or agreement (para 12), the valuation method for

Sabena remained the equity method under the principles based International Accounting

Standards applied for the preparation of the consolidated accounts of the SAirgroup.

29

As soon as the Swiss CEO, together with a number of SAir employees, occupied executive

management positions in the Sabena group 7 and SAirGroupemployees held the majority in the

Steering Committee, the SAirgroup started to outsource airline related activities from Sabena to

the SAirgroup. From the second half of 1996 on, the airline­related activities of Sabena were

restructured and gradually outsourced to the 2 nd pillar of the SAirgroup and this outsourcing

process increased over the years (see also contracts in Appendix A). In 1995 the share of

‘services and goods bought’ in relation to total operating revenue of Sabena was 47%; in 2000

this share had increased up to 73% (Annual Report Sabena Group, 1995 ­ 2000). These services

(e.g. IT­services, catering services, and ground handling services) had now to be bought from the

SBUs of the second pillar of the SAirgroup at inflated transfer prices. Our first example is the

outsourcing of the IT­activities of Sabena to the SAirgroup:

“Atraxis’ first year as an independent information technology company of the SAirgroup was

very challenging… Several reservations and handling systems were delivered to third party

customers and made operational, including the complete migration of the Sabena booking and

handling system.”

(Page 18 Annual Report SAirgroup 1996)

In the outstations Sabena was forced to take Swissport (handling) and Gate Gourmet (catering) as

suppliers (Moser ,2001). The price paid to the SAir units could by agreement deviate 5% of the

current market price for those services at these outstations. In the Brussels hub Swissair, Crossair

(a subsidiary of Swissair) and Swisscargo benefited from very low tariffs charged by Sabena

handling. Further Sabena catering had to pay a fee for technical services to Gate Gourmet (a

subsidiary of the SAirgroup), which was above market rates.

7 An email request of the Secretary General of the Sairgroup to the Secretary General of the Sabena group on 10/4/2001 with regard to which SAirGroup employees did serve on the Board of Sabena or on the Executive Management or on lower but important management functions revealed this information. Besides the CFO, the project leader for the business development plan 1998­2000 of Sabena and the Vice President Marketing and Product were also SAirGroup employees.

30

Another example of the structuring of operations is the take­over of the cargo activity of Sabena

by the SBU SAirlogistics of the SAirgroup, in particular Swisscargo.

“On December 16 1996, Swisscargo and Sabena signed an agreement whereby Swisscargo’s

distribution network would market the entire freight capacity of Sabena’s fleet of aircraft as of

January 1, 1997. Swisscargo thereby enlarged its freight capacity by almost one quarter and is

taking full advantage of the chance to create a cargo hub in Brussels”.

(Page 20, annual report SAirgroup 1997)

In practice this meant that Swisscargo earned revenue from transporting the cargo in the “belly­

space” of Sabena aircraft. Sabena received a reimbursement which did not even cover the direct

costs of transporting the cargo.

In the examples cited above a transaction between business units of the two groups took place at

a certain transfer price. These operating decisions would have been normal operating decisions, if

they had been carried out at arm’s length transfer pricing. The use of not­at­arm’s length transfer

pricing enabled the SAirgroup to shift benefits from Sabena to the shareholders of the SAirgroup

and as a result the profit attributable to the shareholders of the SAirgroup was increased. So these

are in fact examples of related party transactions at non at arms’ length transfer prices which

contribute to the enhancement of the accounting numbers of the SAirgroup and as a result create a

perception of successful economic activity.

These outsourcing decisions using not at arm’s length transfer pricing did not represent normal

economic operating decisions and can thus be classified as accounting choices. The managerial

intent of transferring benefits is admitted in the agreement signed on the 2 nd of August 2001 by

the SAirgroup, the Belgian State and Sabena.

“Agreement of the 2 nd of August 2001between the Belgian State, The SAirgroup and Sabena

Article 6.3

31

The parties and their respective subsidiaries mutually, irrevocably and definitively waive any and

all rights or claims, actual or potential, which they may have against each other and each other’s

directors, officers, employees, agents and representatives for funding or other obligations or

liabilities in relation to (i) any decision adopted or actions taken by the Board of Directors of

Sabena prior to the date hereof regarding the renewal or expansion of Sabena’s fleet; (ii) any

transfer of assets or provision of services between Sabena or any of its subsidiaries and

SAirgroup or any of its subsidiaries prior to the date hereof which purportedly was not effected

on arm’s length­ terms or otherwise not in the best interest of any said parties; (iii) any decisions

adopted or actions taken prior to the date hereof which purportedly deprived Sabena or

Sairgroup or any of their respective subsidiaries from a corporate opportunity; and (iv) any

purported acts or conduct prior to the date hereof as de facto director (“administrateur de fait”)

of Sabena.”

Related party transactions at non at arms’ length transfer pricing is classified in the finance and

economic literature under the heading ‘private benefits of control’. In the extract from the

Agreement of the 2 nd of August we find a number of examples of what is called in the finance

literature ‘private benefits of control’. Theoretical work on private benefits of control is well

developed (see e.g. Grossman and Hart, 1988; Bebchuck, 1999; Schleifer and Wolfenzon, 2002,

Johnson, La Porta, Lopez­de­Silanes and Shleifer, 2002). However, empirical evidence on the

private benefits of control is scarce, by its very nature (Dyck and Zingales, 2004). The

mechanism of transfer pricing is mentioned in the agreement of 2001, but the agreement refers to

other mechanisms of extracting private benefits of control whereby benefits are transferred

without transfer prices being charged from one entity to the other entity. Given that evidence on

private benefits of control is scarce we provide two examples of the latter techniques.

32

During the winter of 1997­1998 the Hunter strategy was developed (see section 1). Besides

investments in airlines, the Hunter strategy also foresaw a change of the “hub concept” of the

group. When the Swiss group invested in Sabena in 1995, it was foreseen that passenger transport

would be organized around two hubs (Zurich and Brussels, whereby inter­continental travel was

organized from the two hubs onwards – see section 4.1.1), the Hunter strategy foresaw only one

central hub for the whole group, namely Zurich. The essence of the Hunter strategy with regard to

network management was increasing inter­continental travel from the Zurich hub (implying use

of the Swissair fleet and increasing Swissair’s passenger revenue). It should be noted that inter­

continental flights are the most profitable routes for ‘traditional’ airline companies. Several

consulting reports prepared in relation to the Hunter strategy foresaw in this mechanism. A

report, prepared in october 1997 stated that passengers can be induced to take less natural choices

through e.g. price advantages or loyalty schemes. This possibility is confirmed in internal

company documents: ‘There is significant additional potential to be exploited with the Hunter­

strategy by rerouting passengers through the Zurich hub’ (Executive Board Meeting, 19 January

1998).

In order to execute this idea the main activities of the airlines Swissair and Sabena in relation to

passenger transport (= marketing, sales, network planning and revenue management) were

centralized in the new Airline Management Partnership [AMP] from mid 1999 onwards.

Employees of the SAirgroup occupied leading positions in the AMP. By controlling network

management, pricing decisions and promotion (i.e. awarding frequent flyer miles) AMP

management was able to influence the buying behavior of customers. As a result, through the

rescheduling of timetables, changing the fare structure of the tickets 8 and awarding of miles,

8 By imposing the same sales price for business class flights from 1999 on in the two carriers (Sabena and Swissair), a passenger could now be switched between two airlines without incurring a price difference on those destinations which were served by both airlines. It is important to note that the “quality perception”

33

many passengers (especially business passengers) now boarded Swissair inter­continental flights

instead of Sabena inter­continental flights. These mechanisms made passenger revenue which

was accounted for directly in the books of the two (still separate) airlines, shift from Sabena to

Swissair. The direct operating costs for flying to those destinations remained with the individual

airlines. The impact of this mechanism can be derived from SAirgroup’s information provided in

the prospectuses 9 . In prospectus issued by the Sairgroup for placements of public debt ( 11

november 1999 US $ 350, 000 , 000 – 7,5 per cent guaranteed notes due 2004) SAir­

management described the vehicle of AMP as “project Diamond: A virtual merger of Swissair

and Sabena”.

Another example of these private benefits of control relates to the diversion of corporate

opportunities from one entity to another. Sabena Technics, the unit of the Sabena Group

responsible for fleet and engine maintenance was a profitable business unit. They had a reliable

reputation and specialized in maintenance of Boeing aircraft and engines, having a substantial

number of third party customers. The future revenue generating power of Sabena Technics

became seriously threatened through two decisions concerning SAiR Technics, the maintenance

company of the SAirgroup. First, in 1997, it was decided that the Sabena fleet was to be

harmonized with the SAirfleet, which meant that the Boeing fleet of Sabena would be quickly

replaced by Airbus aircraft. As a result an important part of the maintenance of the Sabena fleet

was taken over by SAiR Technics, since they enjoyed Airbus expertise. Due to this loss of

maintenance work for their own Boeing fleet, the knowledge base of Sabena Technics for Boeing

of the two airlines differed. The market gave a higher quality rating to the business class of Swissair than to that of Sabena ( De Zitter (2001), see also Airtrack Surveys). 9 Prospectus SAirgroup 5 october 2000, € 400, 000,000 – 6,625% guaranteed bonds due 2010 – page 43: The very nature of the airline business is such that a carrier’s operations are highly leveraged. Each flight has fixed costs such as fuel, fees and labour, while revenue from the flight depends entirely on the number of passengers or cargo carried and the fares paid. This means that any decrease in the number of passengers or cargo carried and/or fares paid results in a disproportionately greater decrease in ptofits. On the other hand, any increase of customer demand which significantly exceeds planning may, in connection with a limited extension of capacity, lead to substantially higher average proceeds per flight.

34

aircraft would diminish which threatened their business with third party customers. Second, only

SR Technics was allowed to perform the maintenance of the new generation engines, which

would replace the current engines used by airlines in the years to come. This decision also

seriously threatened Sabena Technics’ long­term survival in the engine maintenance market.

In the early years (1996­1998) not­at­arm’s­length transfer pricing for services between the

SAirgroup and Sabena was the mechanisms for transfering profits. Later on the system for

transferring benefits became more sophisticated and mechanisms besides transfer pricing were

created to transfer benefits from Sabena to the SAirgroup subsidiaries. In neither of the last two

examples (passenger revenue and the maintenance of aircraft and their engines) did transactions

take place involving transfer prices. In these examples, revenues and costs were altered through

controlling operating and strategic decisions. So evidence of the extraction of private benefits of

control is much harder to detect. Only a careful reading of internal documents reveals the

mechanisms used and this source of information is unavailable to external stakeholders.

Leuz, Nanda & Wysocki (2003) show that the presence of private benefits is an incentive for

earnings management and that earnings management serves to mask the extraction of private

benefits. The negative impact of the transfer of these benefits on the financial statements of

Sabena was to a large extent hidden by several accounting choices in the accounts of Sabena over

the period 1996­1999. Substantial provisions and extra­ordinary depreciations in 1996, in

combination with smaller provisions and depreciations in 1995 and 1997, front­loaded a large

part of the capacity costs of the fleet of Sabena. It was communicated in the Annual Reports of

Sabena in 1995 and 1996 that the restructurings were necessary to safeguard to return to

profitability in 1998 for Sabena.

“In order to smooth the return to profitability the Board of Directors has decided to introduce

some major one­off charges in 1996 to cover restructuring costs in the Horizon ’98 plan and

35

further depreciation for the long­distance fleet. – The Horizon ’98 plan points the way to a return

to profitability in 1998”

(Annual Report Sabena Group,1996, message of the BOD, page 5).

Subsequently real decisions were taken in 1998 and 1999 (e.g. sale and lease back of the

remaining Boeing fleet which was going to be phased out by 2003, sale of fuel hedge and

currency hedge contracts in 1999, together with a sale of investments (Equant shares)) to improve

the reported results in 1998 and 1999 (see graph 4). The underlying weak economic performance

of the Sabena Group was not apparent from its financial statements of 1998 and 1999.

The losses incurred by Sabena would negatively influence the result of the SAirgroup under full

consolidation as well as under the equity method, with an amount equal to the percentage of the

shareholding (=49,5%) multiplied with the loss of Sabena. Through an accounting choice made in

1996 SAir management was able to avoid this negative impact of the losses of Sabena on the

SAirgroup accounts for the years after 1996. The accounting choice consisted of a complete

write­down of the value of the investment in Sabena in the books of the SAirgroup in 1996. This

write down made the net profit of the SAirgroup plummet in 1996 (see graphs 2 and 3); however,

the message in the annual report appears designed to reassure the shareholders:

”In financial terms, the 1996 business year does not yet reflect the broad­based internal progress

that has been made. Nonetheless, a substantial improvement in operating profit, net profit and

cash flow were achieved. The complete write down of the equity stake in Sabena and provisions

for future structural adjustments led to a substantial overall Group loss.

(Annual Report 1996, page 5)

Through this write­down in 1996 a situation “technically similar” to IAS 28 (para 22)

was created which allows for an investor’s share of losses of an associate no longer to be

36

recognised on its annual accounts if they equal or exceeds the carrying amount of an

investment. Although the loss made by Sabena in 1996 was indeed substantial (see graph

4), the share in the loss of Sabena would not have reduced the investment in Sabena in

the books of the SAirgroup to zero in 1996.

The SAirgroup’s accounting decision to completely write­down the investment in Sabena was

accompanied with press releases (in Switzerland and in Belgium) that the write­off did not imply

that the SAirgroup would terminate its cooperation with the Sabena Group, but rather that further

integration was planned. The managerial intent of shielding the total result of the SAirgroup from

the losses of Sabena in the future with this write­down was further revealed in internal company

documents (the original text in French is included in appendix D ).

When Swissair will write down the value of its investment in Sabena in its books, this event is

solely an “accounting” event; it does by no means imply that Swissair will divest from Sabena.

The only objective of this operation is to shield the result of the SAirgroup from future losses of

Sabena. (extract from the letter of the Secretary General of Sabena with approval of the CEO of

SABENA in order to response to questions raised by members of the Belgian parliament – 19th of

March 1997)

‘From an accounting point of view, this write­down allows a company not to include any longer

its share in the losses or profits in the investee. From a strategic point of view, this write­down

does not imply a sale of the Sabena investment nor a withdrawal. (extract from a letter of the

Secretary General of Sabena with consent of the CEO of Sabena to the Cabinet of the Minister of

Transport – 15 March 1997)

37

4.2.2. Accounting choices in relation to the Hunter strategy

The investments made by the Sairgroup in the airlines acquired in the frame of the Hunter

Strategy allow us to carry out a cross­case analysis between the accounting choices made in

relation to the Sabena investment and the accounting choices made in relation to the “Hunter”

investments. The purpose of the cross case analysis is to investigate similarities and differences

and try to uncover identical patterns.

The airline investments under the hunter strategy took place in 1998 and 1999 (see table 1).

Similar to the Sabena investment deal, the SAirgroup in fact controlled these airlines through

agreements.

“The starting point led Swissair to formally comply with the EU ordinance, but de facto to

circumvent this regulation. In order to obtain direct management control immediately as well

as to formally insure the subsequent takeover of a majority interest, the Group had to resort to

complex and difficult management structures, call/put options, portage solutions, guarantee

commitments, as well as multiple tiered and non­transparent intermediate financing “.

(Investigation undertaken at the request of the Administrator of the SAirgroup regarding

Swissair, press release).

Despite the situation of effective control, the acquisitions were valued using the equity method.

Through the equity method the debt of these acquired companies is not shown on the balance

sheet of the SAirgroup. We notice further that LTU and Air Europe were valued at cost in 1998,

the year of their acquisition. All ‘nearly majority’ acquisitions were written down once they were

accounted for according to the equity method. (Air Litoral in 1998, LTU and AOM in 1999 and

in 2000 the investments in the Volare Group followed). In contrast to the presentation of the

write down of Sabena as a single­line exceptional item. The impact of these write­downs on the

result of the SAirgroup in 1998 and especially in 1999 was counterbalanced through positive

38

accrual decisions in relation to other financial assets and the release of half of the provision for

restructuring created in 1996 (see citation from the Annual Report 1996, page 5) and the

aggregated result of these accounting choices was presented under a single line item “results from

operational investments” on the profit and loss account.

After the investment in Sabena was completely written down in 1996, the restructuring of the

operations of Sabena started. A similar pattern is observed in relation to the airlines acquired

under the Hunter strategy. A few citations from the Annual Report of the SAirgroup are listed as

examples below:

“The SAirgroup has amalgamated the charter activities of Balair, Sobelair, LTU, Air Europe

and Volare into the European Leisure Group. The creation of Leisure Cargo GmbH to market

the cargo capacity of the European Leisure Group airlines should make up for the lack of

attention that this segment has received in the past”.

(Annual Report, 1999, page 15)

“In France, the newly­founded SR Technics France began building a total care organization

for the fleets of AOM and Air Liberté”

(Annual Report, 2000, page 35)

Further it was planned that the acquired airlines would join the AMP later.

We thus observe an almost identical pattern of choices (i.e. accounting method choice, accrual

decisions, presentation and structuring of activities, except for the classification of the write­

down (operational versus exceptional item) in relation to all nearly majority acquisitions in EU­

airlines. This may be interpreted as the repeated application of a reporting strategy that had been

shown to be useful so far in transferring benefits to the SAirgroup, despite depleting the

economic resources of the acquired airlines.

4. 2. 3 Accounting choices before the final crash

39

The analysis of the accounting choices over the period 1996­1999 reveals that the prosperous

image communicated by the SAirgroup through its accounting numbers depended to a

considerable extent on accounting choices which had a favourable impact on both earnings and

balance sheet numbers. The underlying economic performance of the SAirgroup was much

weaker than its communicated performance. While the operating result of 2000 almost matches

the levels of prior years operating results, the SAirgroup showed a large bottom line loss (see

graph 2 and 3).

When the financial statements for the year 2000 were finally prepared in March 2001 by the new

CEO, large negative accrual decisions, which were communicated as solutions for the future,

turned the positive operating result turn into a highly negative overall result.

“The realignment of our Group’s overall business thrust requires corrective action in

balance­sheet terms, with the charging of extensive depreciation and provisions to the 2000

results. This will enable the Swissair Group to focus on its new corporate objectives free of the

financial burdens of the past.

(Annual Report, 2000, page 5)

In the message of the CEO in the 2000 Annual Report, the new management team appointed

early in 2001 blamed the foreign airlines in which the SAirgroup had invested for the weak

results (see quotation in section 1). However the operating revenue, the operating profit and the

cash flow of the SAirgroup in 2000 still benefited from the combination of different accounting

choices carried out in the years before. The new CEO even stresses the fact that the 2 nd pillar

SBUs or airline­related SBUs met or even surpassed their targets (see citation in section 1)

40

however the benefits of the 2 nd pillar SBUs were heavily inter­related with profits being

transferred from the airlines of the 1 st pillar and the airlines in which the SAirgroup had invested

to the 2 nd pillar.

If we analyze the subcomponents of the operating profit of the SAirgroup from the launch of the

dual strategy in 1996 up until 2000, we observe that the item ‘gains on the sale of assets’

contributed substantially to the steep increase in operating profit from 1996 to 1997 (see graph 6),

and also to the fact that in the financial year 2000 the operating profit almost matched prior year

figures (1997­1999). The CEO in charge at the balance sheet date [31.12.2000] had discretion

over these real decisions (he was under threat of a performance­related CEO turnover); a few

weeks after the balance sheet date he was dismissed, and the new CEO was restricted to

accounting earnings management methods to affect how the results of the financial year 2000

were reported.

[Insert graph 6 about here]

We observe that both CEOs influenced the result of the year 2000 (see graph 3 and graph 6);

however, each operated in opposite directions (a positive influence through a gain on the sale of

assets of the CEO at balance sheet date versus a negative influence through large negative

accrual decisions of the CEO appointed after the balance sheet date but before the authorization

of the accounts).

4.3 Concluding remarks on the longitudinal analysis of accounting choices

41

The corporate collapse of the SAirgroup came as a surprise to many people. The report

undertaken at the request of the administrator of the SAirgroup was finalized in January

2003 10 and the accompanying press release stated:

“The unconsolidated and consolidated financial statements for 1999 and, to a much greater

degree, for 2000, did not fairly present the economic and financial situation of the

SAirgroup”.

This longitudinal analysis of accounting choices shows that the “foundations” for this unfaithfull

representation of the economic activity were laid in 1996. The disconnection between the

published accounting numbers on firm performance and its financial position and the underlying

economic performance and financial position was marginal at the start, but the gap enlarged

rapidly between 1997 and 1998, and widened drastically in 1999 once the Hunter strategy had

been fully implemented. The disconnection was achieved by a combination of accounting

earnings management and real earnings management.

Studying the reporting deceit that led to this misrepresentation of the economic activity (Lee,

2006) we notice that the accounting choices enumerated above display a significant heterogeneity

in their effect on income. Some choices have both an immediate and a long term effect on income

(e.g write down of the investment in Sabena, choice of the equity method), whereby a long term

choice affects the over time pattern of reported income. Other choices affect the components of

income, period by period (e.g. provision created in 1996, release in 1999).

One could wonder whether the CEO of the SAirgroup had this in mind when he wrote in the

Annual Report of 1996.

“The measures that we have introduced form the basis for a stronger and healthier SAirgroup.

We believe that we have the foundation in place that will enable us to achieve substantially

10 (‘The Investigation Report’ ‘Ernst & Young Bericht in Sachen Swissair’)

42

better results in the coming years, providing an appropriate return on invested capital and

allowing our staff to take advantage of the profit­related bonus scheme that we have created.”

(Annual Report 1996, page 6)

The simulation presented in Appendix E illustrates the impact of the accounting choices on the

published accounting numbers. Three situation are illustrated namely full consolidation of an

investment, equity accounting for an investment and equity accounting combined with a write­

down of the investment. The simulation shows that the choices made by the SAirgroup are the

most favourable for the accounting numbers which represents the performance of the firm and the

financial position.

The behaviour of the SAirgroup in relation to the switch from rules­based standards to principles­

based standards confirm the results of the academic literature, which indicates that the two

different approaches to accounting standards alter neither the incentives nor the ability of

management to report opportunistically; only that the nature and characteristics of opportunistic

reporting vary depending on the nature of the standard. (AAA Financial Accounting Standards

Committee, 2003)

5. Discussion

The purpose of this case study was to gain additional insight into the incentives and methods of

earnings management by using a multi­theory perspective and to deepen our understanding on the

causes and processes which are triggered by this decision to engage in earnings management. In

43

the first part of this discussion section we will analyse the results of the longitudinal analysis on

accounting choices through a multi­theory lens. Next we will turn our attention to the

endogeneity versus the exogeneity discussion. Subsequently we will focus on all the variables

which need to be in place in order to give the CEO the necessary discretion to influence the

accounting numbers in such a manner that his strategic choice was communicated as a successful

one.

5.1 The results of the longitudinal analysis of accounting choices (1991­2000): a multi­theory

perspective on earnings management

If we present the strategic choices and the accounting choices in a time­ordered manner in table 3

(Miles and Huberman, 1998), we observe that most changes in the accounting choices coincide

with the ascent of a new CEO.

Table 3: time ordered presentation of strategic and accounting choices

1991 – 1995: CEO 1 1996 – 2000: CEO 2 2001: CEO 3 Strategic choice airline­focused

strategy Dual strategy Return to the airline­

focused strategy, but divestment in the foreign airlines

Choice of accounting methods or rules

Equity method Equity method Equity method

Judgment Write­down of the investments (1996 for Sabena­ 1998 and 1999 for the hunter airlines Large provision in 1996 for restructuring of airline activities Release of half of the provision in 1999

Large provision for restructuring of airline activities

Real transactions ­structuring of

44

operations which allow a transfer of benefits to the SAirgroup ­structuring of investment contracts (substance versus legal form)

Presentation of the results of the foreign airlines on the profit and loss account of the Sairgroup

As a single line item – share in the results of associated companies

­ Hidden under a single line item ‘results from operational investments’ ­ the write­down of Sabena in 1996 as an exceptional single line item ­the write down of the Hunter airlines aggregated with positive accrual decisions under operating results

As a single line item – share in the results of associated companies

Classification of the results of the foreign airlines on the profit and loss account of the Sairgroup

Classified below the operating results

Classified among the operating results

Classified below the operating results

Disclosures in relation to airline activities

Detailed statistics on the airline activities

­ Disappearance of the detailed statistics ­ creative segment reporting: Swissair (passenger transport) and Flightlease (aircraft leasing) were combined into one segment

Airline statistics appear again seperately from the results of Flightlease

If we combine insights from the upper­echelons theory and strategic choice theory with the

results of the longitudinal analysis of the accounting choices, we notice that the reporting strategy

and accompagning accounting choices are determined simultaneously with the new corporate

strategy. The analysis of the managerial background of the CEO and his career path provides us

with a deeper understanding of the origin of the strategic choice and the interplay with accounting

45

choices which were necessary to present this strategy as successful. We notice that negative

accruals decisions which relate to decisions of the predecessor CEO are classified as single line

items on the profit and loss account, whereas negative accrual decisions with regard to their own

strategic decisions are made less or unvisible through aggregation exercises with accounting

choices with a positive impact. We observe endogeneity between the strategic choice and the

accounting choices, which are part of the strategy implementation process all along the execution

of this strategy.

The longitudinal case data reveal further endogeneity between the voluntary disclosure choices,

the mandatory accounting and disclosure choices and the reporting strategy of presenting the dual

strategy as a successful one.

Taking into account the strategic choice initiated by the CEO provides us with more insight on

the accounting choices adopted by the top managemesnt of a firm. The managerial incentives to

engage in earnings management are simultaneously influenced by the contracts of the firm and

the strategic choice adopted.

5.2 The incentives towards earnings management and the contracts of the firm: the

question of exogeneity versus endogeneity

5.2.1 the external contracts of the firm

In large scale empirical research, authors usually assume that the incentives embedded in the

contracts of the firm have an exogeneous character. We will confront this assumption with our

46

case results. Over time the period studied, the external contracts of the firm did not change. In the

time span of 1991­2000 the EU regulations on the definition of a community carrier did not

change (see section 3.2). Due to the high financing needs of the Sairgroup, the importance of the

contracts with the shareholders and the debtholders increased. The top management of the

SAirgroup learnt in 1997 (minutes of the Finance Committee, 18 august 1997)from a report

prepared by a professor of a Swiss university that in order to receive a favourable credit rating on

the debt market in the coming years it needed to obtain an equity/total debt ratio of 25% up to

35%. The finance committee was told that the situation in 1997 (= equity/total debt ratio : 17,8%)

was unfavourable.

We observe that the accounting choices applied by the SAirgroup since the launch of the dual

strategy make sure those financial figures appreciated by the capital markets and the debt markets

were produced. (see graph 1, 2 and 3 and Table 2). The constant concern for the credit rating of

the SAirgroup in the bond market induced top management to use as many off­balance sheet

financing techniques as possible (e.g. equity method for accounting for the EU­airline

investments, operational lease contracts). The target ratio with regard to the financial structure

(0,25% equity/total debt ratio) was attained in 1999 (see table 2), and the concern to adhere to this

target financial structure is found in several internal documents of the Sairgroup as well as in the

external communication. The CEO of Sabena, an employee of the SAirgroup wrote in the

summer of 2001, the following to a Belgian Judge.

Currently Sabena’s balance sheet contains a liability of 98 Billion BEF. This is the main reason

why Swissair cannot consolidate Sabena because the market capitalisation of Swissair is at the

level of 1.2 billion Swiss Francs. (extract from a letter of the CEO of Sabena to the President of

the Commercial Court in Brussels on 28.6.2001)

47

The case data allow us to conclude that the contracts with the capital markets, the debt market and

the regulatory authorities are exogeneous in relation to earnings management in the case of the

SAirgroup, but what about the internal contracts?

5.2.2 The internal contracts of the firm

We observe the constant pressure of the implicit contracts of the firm. CEOs are to deliver results

above average industry performance otherwise they are threatned with a CEO­replacement.

Philippe Bruggisser kept operating profit levels almost constant over the years with the use of

gains on the sale of assets. So the implicit internal contracts remain unchanged over the time span

studied and have an exogeneous character.

The explicit internal contracts of the firm however have changed over the years. We focus first on

the explicit internal contracts with management. The remuneration contracts changed twice over

the time span studied. Each time the altered remuneration contract applies from the second year

that the new CEO is in office. We observe that the first year of a CEO is characterized by

accounting choices with a long term impact. These choices will have a favourable impact on the

indicators embedded in the incentive schemes which become effective the year after (see also

citation in 4.2.3). For example from 1997 on the bonus scheme of top executives of the

SAirgroup was determined mainly by the following two indicators, the EBIT of the SBU in which

a manager was active and the net group result of the SAirgroup. Both indicators were favourably

influenced by the accounting choices applied (equity method with write­down and non at arm’s

length transfer pricing and control of corporate opportunities) Next to the bonus, top managers

enjoyed from 1997 on the benefits of a stock option plan of which the rights were exercisable

after a period of three years. The new CEO of the Sairgroup who came into office in 2001 had

48

developed a new remuneration system, which would have become operative from 2002 onwards.

This system benefited from accounting choices he had taken in 2001.

Agency research usually assumes that the reward system in place creates the incentives to make

specific accounting choices in order to obtain the desired personal wealth effects for managers in

line with the existing plan. As such the incentives embedded in the remuneration contract are

assumed to be exogeneous. The case data show that in order to ensure that accounting choices are

made in line with the reporting strategy (or at least not opposed to it), the reward system itself and

the incentive embedded in the remuneration contract becomes the dependent variable. This

implies a reversed causation in order to allow the necessary accounting choices which will

provide the desired accounting numbers when the internal contract is adapted.

5.2.3 .the contract with the Board of Directors: the quality of board monitoring

Some authors consider the relationship between the Board of Directors as an internal contract.

We will thus analyse this contract and find out whether we observe changes over the time span

analysed (1991­2000). At the end of 1998 a revision of the Swiss Federal Aviation Act abolished

the need for board representation by the public institutions and paved the way for a reduction of

the Board of Directors. The large majority of the Board members saw their directorship come

finally to an end early in 1999. This implies that when hunter investments had to be approved by

the Board, many of the members were at the end of their mandate. The short­term horizon

problem, which is studied in relation to CEOs, might also be an issue in the governance process

by boards. “Short term horizon” in relation to boards might not imply an extra incentive to

manage earnings, but might point to the conclusion that their desire to monitor might be less.

Further the fact that two acquisitions (LTU and Air Europe at the end of 1998) are presented

49

according to the cost method to this outgoing Board might point at endogeneity between board

events and accounting choices (see accounting choices in relation to the hunter strategy).

The study of the Board characteristics provides another example of this causality reversal. Under

the agency paradigm, earnings management is expected to be greater when board monitoring is

weak. The case data provide evidence however that the composition of the board may be adapted

in advance to allow a range of decisions, including earnings management, to take place (see

change of the Swiss Aviation Act which resulted in changes of the Board composition and

structure). Further large companies are more influential than small companies with regard to

shaping regulation or codes issued by regulatory authorities (e.g. change in Swiss Aviation Act).

As such regulation (which is an external contract) might be endogeneous for large firms, whereas

the same regulation has an exogeneous character for the smaller firms.

The case data reveal that the exogenous or endogenous character of the variables

involved driving earnings management, depend on whether or not a firm is able to

renegotiate or influence the contract.

5.3 Variables influencing the available discretion to engage in earnings management

Traditional agency research revealed a number of company characteristics and institutional

characteristics which create discretion for earnings management purposes (see literature review).

If we turn our attention to company characteristics and agency costs we observe that all EU­

hunter airline investments were made in non­listed companies. After the investment deal with the

SAirgroup, the ownership structure of the Hunter airlines was changed into a concentrated

ownership structure with two major shareholders. Agency research shows that the degree of

50

ownership concentration affects the nature of contracting and research results are available that

demonstrate that accounting informativeness declines as ownership concentration increases

(Dempsey, Hunter & Schroeder, 1993; Warfield, Wild & Wild, 1995; Donelly & Lynch, 2002;

Fan & Wong, 2002).

If we consider institutional elements we notice that the Sabena investment and the EU­hunter

investments were made in countries which are characterized by low quality accounting

standards (Pope & Walker, 1999; Ball, Kothari & Robin; 2000; Ali & Hwang, 2000), a

low degree of investor protection (LaPorta, Lopez­de­Silanes, Shleifer & Vishny, 1997;

LaPorta, Lopez­de­Silanes & Shleifer, 1998), a low risk of litigation (Ball, Kothari and

Robin, 2000; Leuz & Verrechia, 2000) and a low degree of enforcement (Hope, 2003).

We therefore conclude that we not only observe a pattern of identical reporting choices made by

the SAirgroup in relation to Sabena and the EU­hunter airlines, but that we also observe that the

ownership characteristics and the institutional environment of these airlines are virtually identical.

Extant research points almost exclusively at available discretion which is created by

environmental, institutional and firm characteristics. The case data however reveal that in order to

pursue his reporting strategy a CEO needs to create internal company discretion as well. In order

to present the dual strategy and the Hunter strategy as successful, accountting choices were part

of the implementation process of the strategy. These choices did not only involve accounting

earnings management decisions; they involved real decisions as well facilitating the transfer of

benefits from certain entities of the group to other entities. This implies that the corporate CEO

needs a lot of discretion or at least no resistance for his policy from the CEOs of the different

SBUs of the group. This discretion was achieved by changing the degree of centralization, by

changing the task responsibilities of top managers of the SBUS and by adapting the incentive and

51

reward systems of those individual SBU managers together with replacements of top team

members.

A number of decisions critical to the transfer of benefits were being centralized in the hands of

the corporate CEO. For example from 1999 on, all operational decisions with regard to the

airlines Sabena and Swissair (i.e. network and revenue management, marketing and sales) are

centralized in the newly created Airline Management Partnership. The CEO in charge of the

AMP became Philippe Bruggisser, the corporate CEO of the SAirgroup, and he decided on the

structure of ticket pricing between the two airlines and imposed the same fares on Sabena and

Swissair which made business passenger revenue shift from Sabena to Swissair (see section

4.2.1). This centralization changed drastically the task responsibilities of the CEOs of the

individual airlines. When the American CEO of Swissair resigned mid 2000, his complaint was

that he never received the authority and responsibility to run the airline as he wished:

“Find the best person in the world to replace me. But give him the necessary responsibilities

so that he can run the airline like he wants. Do not underestimate the importance of this point.

The fact that I was not able to stay in the company was due to the fact that this leadership

question was not taken care of.

(Translated from Luchinger, page 260, extract from the resignation letter of J. Katz).

The need for accounting discretion over a business unit will not only have an impact on the

degree of centralization and the division of task responsibilities between top team executives, but

also the choice of the performance indicator in the bonus plan of that executive will be influenced

by the need to make certain accounting choices in view of the reporting strategy. The incentive

schemes for the individual top team members were constructed in such a way that the CEOs of

the SBUs would not oppose the earnings management policy of the corporate CEO. In case of a

detrimental impact of a choice necessary to pursue the overall strategy (reporting strategy

inclusive) on their business unit results, the CEOs of the SBUs were shielded to a certain degree

52

(which could vary) from this negative impact (e.g. a part of the bonus plan of the top executives

of Sabena was tied to the net result of the SAirgroup and the top executives of Sabena took also

part in the share option plan of the SAirgroup, like the SAir­executives). When the accounting

choices were beneficial for the units, the top team members benefited from both the real decisions

and from the ‘pure’ accounting decisions through their bonus plan.

So the analysis of the case data allows us to uncover additional elements of discretion on top of

the results of the agency literature. The data indicate that in order to implement the “necessary”

accounting choices the following variables needed to be adapted namely the composition of the

dominant coalition, the organizational design, the design of the management control system

(degree of centralization, the division of task responsibilities and the incentive and reward

structures) and a change in the characteristics of the investments under the hunter strategy.

If we summarize the findings of this case study and combine them with the insights from the

extant accounting literature, then figure 2 presents the contribution of our study in terms of

managerial incentives which drive the decision to engage in earnings management and the

creation of the necessary discretion to do so to the existing literature in a schematic way.

[ insert Figure 2 here ]

53

5. CONCLUSIONS

In this paper we have attempted to broaden the perspectives taken in studying earnings

management, responding to earlier critiques of the lack of progress it has made (Fields, Lys and

Vincent, 2001), and the call for more field­based work (Bernard and Skinner, 1996). Using a

case study we have tried to gain more insight into the drivers of earnings management and the

underlying process by an in­depth analysis of the reporting strategy and the use of accounting

choices by a single group of companies over a time span of 10 years. To advance our

understanding of earnings management we have studied the reporting strategy and the

accompagning accounting choices from a multi­theoretic perspective. This multi­theory lens has

provided us with findings in relation to the extant agency literature which conflict with some of

its underlying assumptions as well as with additional insights into the process of earnings

management.

First, earnings management research, although being a mature research area, has generally failed

to distinguish whether accounting choices have an endogenous or an exogenous role (e.g. Fields,

Lys & Vincent, 2001). Using a multi­theoretical perspective we find that the direction of the

causation assumed in the agency framework is often reversed. A number of incentives embedded

in contracts become dependent on the reporting strategy and accompanying accounting choices

which are endogenously determined with the strategic choice of the top management team of the

company. The data provide evidence that when contracts of the firm can be rewritten the direction

of the causality is reversed whereby the reporting strategy and accompanying accounting choice

becomes the independent variable and the incentive embedded in the contract of the firm becomes

the dependent variable.

54

Second the data reveal that the earnings management strategy with the accompagning accounting

choices are determined simultaneously by the non­negotiable contracts of the firm and the

strategic choice of top management. When reporting choices are part of the corporate strategy,

the disconnection between the published performance and the underlying economic performance

can continue as long as real operational decisions and pure accounting choices are able to mask

the situation. Terminating earnings management in these situations requires a complete re­

orientation of the strategy, restructuring of activities, redesign of the organization and changing

the management control systems back to those required to meet real business needs in terms of

the available market opportunities.

Third, this multi­theory analysis has uncovered a number of additional variables, which might

enlarge the discretion of the CEO to engage in earnings management. These variables include the

composition of the top team of executives, the organizational design, the investment

characteristics and the management control system. Several different aspects of the management

control system might be influenced (e.g. the degree of centralization, the division of task

responsibilities and the choice of the measures used in the incentive systems).

Finally the case results reveal the limitations of current research methods employed to study

earnings management. Most models assume a one­year impact of accounting earnings

management decisions in response to incentives. The case data reveal that accounting choices

consists of a portfolio of choices with long term effect on the pattern of income over time in

combination with choices with short term effect. These more fundamental types of earnings

management cannot be detected and studied using current research designs. This implies that we

55

only have acquired knowledge of a fraction of the totality of earnings management techniques

which can be used to suggest that company performance is better than it actually is.

We believe that earnings management is an important economic issue and requires to be

studied using a wider range of methods and techniques, including further case­based

work. Managers appear to use a wide variety of techniques, involving both real decisions

and accounting decisions, to enhance their reported performance and to potentially

extract private benefits unrelated to the underlying economic performance of the

organizations they manage. Studying only accruals methods of earnings management

allows us to see just the tip of the iceberg.

56

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Appendix A: Overview of documents and publications consulted

Minutes of Meetings

Minutes of the Board of Directors of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (october) Minutes of the Management Committee (konzernleitung) of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (october) Minutes of the Finance Committee of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (August) Minutes of the Executive Committee of the Board of Directors of the SAirgroup (Ausschus der Verwaltungsrat): 1996 – 1999 (april) ­ Committee was abolished in april 1999 due to the reform of the Board of Directors Minutes of the Board of Directors of Sabena and agenda with accompagning documents: 1994 – 2001 (november) Minutes of the Management Committee of Sabena and agenda with accompagning : 1994 – 2001 (november) Minutes of the Workers’ Council Meetings : 1994 – 2001 (november) Minutes of the Steering Committee SAir/Sabena: May 1995 – March 1998 Minutes of the Steering Committee Diamond – 1999 (n° 1 – n° 9) Minutes of the AMP (Airline Management Partnership)­ Management Committee Meeting (october 1999 – october 2001)

Contracts

Shareholders’ and Master Agreement between the state of Belgium and Swissair Swiss Air Transport Company LTD – 4 May 1995 Loan Agreement between Société Féderale d’Investissement (Belgium) and Swissair – 24 July 1995 Global Warrant Certificate and Terms of Warrants – 25 july 1995 Cooperation Agreement between Sabena and Swissair, Swiss Air Transport Company – 24 july 1995 Codeshare beyond Agreement between Swissair and Sabena, 1 june 1997 Frame Agreement between Swissair Swiss Airtransport Ltd and Sabena NV concerning the cooperation in the area of cargo transportation – 16 december 1996 Cooperation Agreement between Sabena NV and Swisscargo Ltd concerning the cooperation in the area of cargo transportation – 12 august 1997 Fleet Cooperation Agreement, 18 december 1997 between Swissair, SAirgroup, SR Technics, Sabena, DAT and Sobelair (the latter two are subsidiaries of Sabena) Technical Assistance and Service Agreement (TASA) between Sabena and Gate Gourmet Internationa Ltd (subsidiary of SAirgroup) on 5 february 1997 (relates to catering) Swissair/ Sabena Airline Management Partnership (legal establishment of the UK partnership) – Allan & Overy, London 31sth of July 2000

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Consulting Reports

Report prepared on a possible acquisition – Flair Report – (24 May 1994) – Mc Kenzie Report on a multi­partnership strategy – (3 october 1997) – Mc Kenzie Several reports on the Hunter Strategy – (30 october 1997, 1 december 1997, 14 january 1998, 3 february 1998) Several reports on project Diamond – (april 1999, June 1999,december 1999) – Mc Kenzie Several reports on project Diamond, exclusively on the cost­ benefit sharing model under project Diamond = AMP (july 1999 – november 1999) – Roland Berger Several consultancy report on AMP (december 1999 – january 2000) – Mc Kenzie AMP – Clean Slate report – march 2000 – Mc Kenzie Strategic options for Sabena Technics – 16 september 1997 – Mc Kenzie Situation of SR/SN prepared for Sabena – 7 november 1997 – Mc Kenzie Development and Evaluation of Strategic Options ­ catering – Sabena 26 august 1997 ­ ICARUS – consulting AG: Development and Evaluation of Strategic Options ­ cargo handling – 26 August 1997 ­ ICARUS – consulting AG: Strategic Options for Sabena Ground Handling – 16 september 1997 – Mc Kenzie PWC­Valuation of the maintenance division – Sabena Technics – 1 january 1999 Report for the financing of Aircraft – Sabena – March 1999 ­ Crédit Lyonnais – Transportation Advisory Group Selecting the best strategy to value the state participation in Sabena – report for the Board of Directors of Sabena ­ november 1999 – Boston Consulting Group Project Nightfly : strategic perspective on shareholder negotiations – (december 1999 – March 2000), ­ ING Bearings – report ordered by the Minister of public companies Project Daylight – ING Bearings – May 2001 Blue Sky – several consulting reports prepared for Sabena – by the Boston Consuling Group (spring 2000 – march 2001). Warburg Dillon Read – comments on financial guidelines of the SAirgroup – 29 september 1999 CSFB – comments on financial guidelines of the SAirgroup – november 1999 Project Shield – october 2000 – Mc Kenzie Risk assesment and strategy – March 2001 ­ CSFB

Reports of Auditors

Management letters of the auditor of Sabena (KPMG) (1995, 1996, 1997, 1997, 1998, 1999, 2000) Sabena­ Opinion on the proposed capital increase – december 11, 2000 ­ KPMG Report of STG Coopers and Lybrand to the Finance Committee and to the Board of the SAirgroup (1995, 1996, 1997) Management Report of PWC to the Finance Committee and to the Board of the SAirgroup(1998, 1999, 2000) Financial Exposure Report of PWC to the Board of the SAirgroup – february 2001

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Audited Results for the half year to 30 june 2001 to the Board of the SAirgroup of KPMG

Prospectusses issued by the SAirgroup

. SAirGroup – SAirGroup Finance (NL) B.V. –– € 400,000, 000 – 4.375 per cent ­ Guaranteed Bonds due 2006 ­ Guaranteed by SAirgroup – date 11 th of November 1999 . SAirGroup – SAirGroup Finance (NL) B.V. – U.S. $ 350,000,000 Guaranteed Notes due 2004 – Guaranteed by SAirgroup – date 11 th of November 1999 . Prospekt SAirgroup 2000 – 2007 von CHF 300 000 000, 41/4% Anleihe (loan) SAirgroup – date 25 th of Januar 2000 . SAirGroup – SAirGroup Finance (NL) B.V. ­ € 400,000,000 – 6.625 per cent. Guaranteed Bonds due 2010 – Guaranteed by SAirgroup – date 5 th of October 2000

other documents Correspondence of the CEO, the Secretary General and the legal deparment of Sabena 1995­2001 The Annual Reports of Swissair/ SAirgroup 1945 ­ 2000 The Annual Reports of Sabena 1990 – 2000 Financial Statement Swissair Group for the 6 months ended 30 june 2001 Sabena Development Plan 1998 – 2000 Sabena Development Plan 2000 ­ 2002 Remuneration contracts of CEO Sabena 1996­ 2000 and 2000 – 2001, CEO SAirgroup 1996 – 2000, CFO SAirgroup 1997 – 2000, CEO Swissair 1997­1999 (details of the remuneration contracts of the other SBU CEOs were found in the Ernst & Young Report – complete version) Bonus and stock option plan SAir­ Executives ­ 1997 – 2000 Bonus and stock option plan Sabena – Executives – 1999 ­ 2000 Presse maps of Sabena and SAirgroup – 1995 ­ 2001

Reports, documents, articles and books

Chambre des Représentants de Belgique. (2003) ENQUÊTE PARLEMENTAIRE visant à examiner les circonstances qui ont conduit à la mise en faillite de la Sabena, de déterminer les éventuelles responsabilités et de formuler des recommandations pour l’ avenir. DOC 50 1514/003 and DOC 50 1514/004 Decraene, S., Denruyter and P., Sciot, G. (2002) De crash van Sabena. Leuven, Uitgeverij Van Halewyck Lüchinger, R. (2001). SWISSAIR l’histoire secrète de la débâcle. Lausanne, Editions Bilan, Moser, S. (2001). Bruchlandung, wie die Swissair zugrunde gerichtet wurde Zürich, Orell Füssli Verlag Presse Report of Ernst and Young ‘investigation in Sachen Swissair’ Ernst and Young Report – complete version ‘investigation in Sachen Swissair’ report undertaken at the request of the administrator of the SAirgroup Slits, V. (2004)., “Comment Swissair a pillé la Sabena.” La Libre Belgique, 17 th of November 2004, 1:18­19.

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T.M. and D. M. (2004). “La théorie du complot, ou la tentation de réécrire l’histoire.” Le Temps – Quotidien Suisse édité à Genève” 17 th of November 2004, n° 2034, 3.

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Appendix B: Definition of Control in the 7 th Directive

the concept of legal control defined by the 7 th Directive in Section 1, article 1 point 1.

A member state shall require any undertaking governed by its national law to draw up

consolidated accounts and a consolidated annual report if that undertaking (a parent

undertaking):

(a) has a majority of the shareholders’ or members’ voting rights in another undertaking

(a subsidiary undertaking); or

(b) has the right to appoint or remove a majority of the members of the administrative,

management or supervisory body of another undertaking, (a subsidiary undertaking)

and is at the same time a shareholder in or member of that undertaking; or

(c) has the right to exercise a dominant influence over an undertaking (a subsidiary

undertaking) of which it is a shareholder or member, pursuant to a contract entered

into with that undertaking or to a provision in memorandum of articles of association,

where the law governing that subsidiary undertaking permits its being subject to such

contracts or provisions. A Member State need not prescribe that a parent undertaking

must be a shareholder in or member of its subsidiary undertaking. Those Member

States the laws of which do not provide for such contracts or clauses shall not be

required to apply this provision, or

(d) is a shareholder in or member of an undertaking, and: (aa) a majority of the members

of the administrative, management or supervisory bodies of the undertaking (a

subsidiary undertaking) who have held office during the financial year, during the

preceding financial year and up to the time when the consolidated accounts are drawn

up, have been appointed solely as a result of the exercise of its voting rights; or (bb)

controls alone, pursuant to an agreement with other shareholders in or members of the

undertaking ( a subsidiary undertaking), a majority of shareholders’ or members’

voting rights in that undertaking. The Member States may introduce more detailed

provisions concerning the form and the contents of such agreements.

The Member states shall prescribe at least the arrangements referred to in (bb) above.

They may make the application of (aa) above dependent upon the holding’s representing

20% or more of the shareholders’ or members’ voting rights. However (aa) above shall

67

not apply where another undertaking has the rights referred to in subparagraphs (a), (b) or

(c) above with regard to that subsidiary undertaking.

Next to the concept of legal control the 7 th directive foresaw the option for the member

states to implement the concept of effective control in their laws. The case of effective

control has a residual character. This implies that the legal power of control and effective

control cannot be combined in the same subsidiary. The 7 th Directive states in section 1,

article 1, point 2: “Apart from the cases mentioned in paragraph 1 above and pending

subsequent coordination, the Member States may require any undertaking governed by

their national law to draw up consolidated accounts and a consolidated annual report if

that undertaking (a parent undertaking) holds as participating interest as defined in article

17 of Directive 78/660/EEC in another undertaking ( a subsidiary undertaking), and: (a) it

actually exercises a dominant influence over it; or (b) it and the subsidiary undertaking

are managed on a unified basis by the parent undertaking. “ Only a few Member States

in Europe Union have introduced the concept of effective control in their national laws.

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Appendix C: Definition of Control in the International Accounting Standards in the nineties

In the 1990s the definition of control of the International Accounting Standards was

embedded in IAS 22 ‘Business Combinations’ as well as in IAS 27, ‘Consolidated and

seperated financial statements’. Both definitions were identical and defined the concept

of control as follows: Controll is the power to govern the financial and operating policies

of an entity so as to obtain benefits from its activities (par 4 – IAS 27). In order to allow

preparers of financial statements to judge whether or not control existed in a relationship

between investor and investee the following principles were included in IAS 22 and IAS

27 (again these principles are identical). These principles are the following (IAS 27 – par

13):

Control is presumed to exist when the parent owns, directly or indirectly through

subsidiaries, more than half of the voting power of an entity unless, in exceptional

circumstances, it can be clearly demonstrated that such ownership does not constitute

control. Control also exists when the parent owns half or less of the voting power of an

entity when there is:

(a) power over more than half of the voting rights by virtue of agreement with other

investors;

(b) power to govern the financial and operating policies of the entity under a statute or

agreement;

(c) power to appoint or remove the majority of the members of the board of directors or

equivalent governing body and control of the entity is by that board or body; or

(d) power to cast the majority of votes at meetings of the board of directors or equivalent

governing body and control of the entity is by that board or body.

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Appendix D:

S’il est possible que Swissair amortisse la valeur de sa participation en SABENA, il est acquis

qu’un telle opération purement comptable n’entraînera en aucune manière le retrait de Swissair.

Cette opération aurait pour seul objectif de ne plus faire intervenir les résultats de la SABENA

dans la consolidation des résultats du groupe. (extract from the letter of the Secretary General of

Sabena with approval of the CEO of SABENA in order to response to questions raised by

members of the Belgian parliament – 19th of March 1997)

‘Sur le plan comptable, l’amortissement d’une participation permet à une entreprsie de ne plus

devoir consolider cette participation, et donc de ne plus inclure dans ses résultats les profits ou

les pertes de cette participation – Sur le plan stratégique, cet amortissement ne signifie pas une

vente ou un retrait’ (extract from a letter of the Secretary General of Sabena with consent of the

CEO of Sabena to the Cabinet of the Minister of Transport – 15 March 1997)

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Appendix E: Illustration of the impact of the accounting choices of the SAirgroup

The following accounting methods will be applied to an example of two individual companies A and B, whereby A holds an investment in B of 49%. The group accounts will be prepared under three different sets of accounting choices: set (1) full consolidation, set (2) equity method and set (3) equity method whereby the investment was written down in the prior year.

Individual accounts A

Individual accounts B

Group accounts

Group accounts

Group accounts

Full consolidation

Equity method

Equity method with write down

Tangible Assets

600 700 1300 600 600

Investment 196 172 Current Assets 504 350 854 504 504 Total Assets 1300 1050 2154 1276 1104 Capital 500 400 500 500 500 Reserves 200 200 200 4 Result of the year

50 (50)

Group result 26 * 26 50 Minority interests

178

Long term debt

400 500 900 400 400

Trade creditors

150 200 350 150 150

Total liabilities + Equity

1300 1050 2154 1276 1104

Equity/(Equity + total debt

33 % 56 % 50 %

Return on Equity

3,7 % 3,7 % 9,9 %

Return on total assets

1,2 % 2 % 4,5 %

* group result = 50 – 24 (= share of the loss of B) = 26

71

Figure 1

72

Figure 2

73

Graph 1: Operating Revenue Swissair/Sairgroup 1984­2000 in CHF mio

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

2000 1998 1996 1994 1992 1990 1988 1986 1984

Individuele accounts Swissair

Group accounts Swissair/SAIR group

Hunter strategy

Dual strategy

___ operating revenue

74

Graph 2: Net income Swissair/SAirgroup1984­2000 in CHF mio

­3500

­3000

­2500

­2000

­1500

­1000

­500

0

500

1000

2000 1998 1996 1994 1992 1990 1988 1986 1984

Net Income

Source: Financial Statements Swissair Group/SAirgroup

75

­3000

­2500

­2000

­1500

­1000

­500

0

500

1000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Graph 3: Swissair/SAirgroup operating result and net result in mio CHF

operating result net result

Source: Financial Statements Swissair Group/SAirgroup

76

Graph 4: Overview of the operating result and the net result of the Sabena Group in mio BEF

­14.000

­12.000

­10.000

­8.000

­6.000

­4.000

­2.000

0

2.000

4.000

6.000

1992 1993 1994 1995 1996 1997 1998 1999 2000 operating result

net result

Source: Financial Statements of the Sabena Group

77

Graph 5: Evolution flight revenue versus other revenue in mio CHF of the Swissair/SAirgroup

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Flight revenue Other revenue Total revenue

Source: Financial Statements Swissair Group/SAirgroup

78

Graph. 6: The impact of "gain on sale of assets" on group operating profit in mio CHF.

0

100

200

300

400

500

600

700

800

1995 1996 1997 1998 1999 2000

group operating profit excl. gain on sale of assets

gain on sale of assets

group operating profit

Source: Annual Reports Swissair/ SAirgroup